Why we need to think about the next crash now

This is cross-posted from New Banking UK

Financial regulators have to be adept at shutting the stable door after the horse has bolted – and especially so in England, where decades of persuasion are usually required to persuade politicians that the horse has left the stable at all.

Minute examination of its straw continues for some time while everyone else can see the animal rampaging round outside, seeking whom it will devour.

The problem is that the English, as I may have mentioned before – and it is the English not the Scots – are a deeply conservative breed when it comes to money.

They also have a blind spot about it.  They still believe things are exactly the same as they were in the 1950s, with Captain Mainwaring at his desk dispensing sherry, when he has long since been pensioned off in favour of risk software at regional office.

Take share trading for example.  The English still believe, along with other economic fundamentalists in the USA, that markets will always create an accurate price.  This is the Efficient Market Hypthesis by Chicago economist Eugene Fama.

Fama and his colleagues came up with the idea in 1970 but recent events have shown that it is almost certainly wrong, and disastrously so.  Or so you would have thought.

It doesn’t help that most of thinking about the financial markets which now dominate the world is done behind closed doors. But there are a few thinktanks which now specialise in it – the Institute for Market Dysfunctionality at the LSE is one.  The Capital Institute in New York is another.

Both were founded by people with successful careers in the financial markets.  John Fullerton at the Capital Institute had 18 years at J. P. Morgan.

So I take his warnings seriously.  When he says that algorithmic trading threatens the stability of the global economy, you have to listen.  This is what he says:

“Scientists understand that, in any given system, there is a need to balance system efficiency (resulting in high throughput) with system resilience (resulting in an ability to withstand shocks).  Yet in the case of financial markets, the balance has tipped too far in favor of speed and perceived efficiency, leaving markets highly brittle and more susceptible to collapse.  High degrees of financial leverage compound this, leaving them vulnerable to events like the 2008 financial crisis and the numerous mini-crashes that have occurred since and are continuing…”

Unfortunately, the regulatory system in the UK tends to be busy fighting the last war and congratulating itself on its success in preventing it, without realising that something very different is on the cards.

But don’t let’s pre-judge the new arrangements which have just come into effect.  The coalition has taken financial regulation seriously and have a different approach to it, so there is hope.

But it matters, for example, that nobody is at the controls of the giant trading machine.  It matters that the combination of algorithmic trading on a huge scale, and the trading of obscure derivatives, can plunge us into a darkness on a scale way beyond the banking crash of 2008.

It matters that people like Fullerton can see us accelerating towards the next financial crisis far faster than usual.

This is a key question for whoever forms the next government in the UK.  It needs to be very high up in the rival manifestos – both how to prevent the looming crash (a financial transactions tax, as Fullerton suggests) and how to deal with it once it has happened (creating the money to pay of the unrepayable debt hole perhaps).

But will it be?  Unfortunately, we are still in the process of minutely examining the straw in the stable…